1031 Exchanges and Closing Costs

We are often asked this question.  Or perhaps it is asked, “Do I have to replace the net sales price or full sales price of the property I am selling to fully defer my tax?”

Very little specific authority exists for the deduction of transactional costs from realized and recognized gain.  The Internal Revenue Service has never published a complete list of qualifying expenses and only one official ruling has been issued on the subject.  However, the IRS has provided some signal of what can be deducted from the costs in calculating the replacement value requirement.

Revenue Ruling 72-456 provided guidance indicating brokerage commissions can be deducted from the exchange proceeds. In IRS Private Letter Ruling 8328011, a taxpayer was allowed to deduct other transactional costs if they are paid in connection with the exchange.  IRS Form 8824 provides for transactional costs that are referred to as “exchange expenses” that can be deducted.

EXCHANGE EXPENSES
Exchange expenses are those expenses which result solely as a result of the sale or acquisition of property and other costs directly related to the sale or acquisition of real estate or in connection with the 1031 Exchange (transaction expenses). These may include:
Real estate commissions                                    Closing or escrow fees
Title insurance premiums                                   Legal fees
Transfer taxes                                                      Notary fees
Recording fees                                                     Qualified Intermediary fees

NOT EXCHANGE EXPENSES:
Costs related to obtaining financing should not be deducted from the proceeds:
Mortgage points or interest                                Credit reports
Lender’s title insurance                                      Mortgage insurance
Loan origination or application fees                                Assumption fees

Other transactional items typically found on a closing statement are not exchange expenses and probably do not reduce the amount realized or recognized and are not added to the basis of the replacement property:
Pro rata property taxes                                       Utility escrow deposits or charges
Association fees                                                   Hazard insurance premiums
Tenant security deposits                                    Pro rata or prepaid rents

These lists are not meant to be inclusive.  A taxpayer should review their individual transaction and closing costs with their tax and/or legal advisors to determine whether costs related to the closing are exchange expenses or not.